It’s A Flood Of Unsponsored ADRs!

American Depository Receipts of over 50 Indian companies including TCS, Bajaj Finance, Apollo Tyres, United Breweries, Zee Entertainment, Titan, NTPC, Britannia, Unitech, Power Grid, Motherson Sumi, Tech Mahindra – will soon be trading over-the-counter in the US and many of these companies may not even be aware of this!

Last year the government notified a new depository receipts scheme that permitted the establishment of Level 1, sponsored and unsponsored ADRs for the first time. Level 1 ADRs are non-capital raising ADRs. An unsponsored ADR program is established by a foreign depository bank, without the participation or consent of the company whose shares underlie the ADR. Unsponsored ADRs trade only in the US O-T-C market. Competing depositories can establish multiple unsponsored ADRs for the same company. And an unsponsored ADR and a sponsored ADR cannot co-exist. So if a company wants to do a sponsored ADR then it has to have the unsponsored facility terminated.

UNSPONSORED ADRs- Trade in US O-T-C market only- Competing depositories can create multiple ADRs for same company- Unsponsored and Sponsored ADRs cannot co-exist- Unsponsored ADR to be terminated if Sponsored ADR established

The new scheme applies conditions to unsponsored ADRs – the DR holder must get voting rights and the DRs must be listed on an international exchange- that means a platform for trading depository receipts, which is in a permissible jurisdiction, is accessible to the public for trading and provides pre & post trade transparency.

DEPOSITORY RECEIPTS SCHEME, 2014

Unsponsored DRs can be issued only if - DR holder gets voting rights- DRs are listed on an International Exchange

The scheme came into effect on December 15th and since then, Bank of New York Mellon and other foreign depository banks have made a slew of filings for Level 1, unsponsored ADRs on the back of Indian shares. When will all these ADRs start trading? And what impact could these unsponsored ADR programmes have on the Indian companies, involved…well actually uninvolved! To talk about that, CNBC-TV 18’s Menaka Doshi speaks to Rajiv Gupta of Latham Watkins and Varoon Chandra of AZB.

Doshi: When will these ADRs commence trading? First a process question- how does it work? Does the foreign depository get its Indian arm to buy shares in India then convert them into ADRs and then sort of market or sell those ADRs to investors in the US or does an Indian shareholder go to a foreign depository and get this process going?

Gupta: The initial process is really to establish the ADR program which as you just noted Bank of New York Mellon (BNY Mellon) and few other depositories have already established for some of the Indian clients, Indian issues. The next step would be that when these deposit programs go effective- as I understand there are still certain SEBI regulations that are supposed to come out and clarify few things - but once it goes effective the actual process is pretty simple.

An ADR holder can instruct a broker in India and ask them to buy shares on their behalf in India and then take them to a depository, say BNY Mellon, and say I want ADRs in return. BNY takes those shares and will issue ADRs to that investor. Once they start trading the other option for the ADR holder is to buy in the over-the-counter (OTC) market once they start trading in the OTC market. So the process is quite simple once the ADR is effective.

Doshi: Can an Indian shareholder approach a foreign depository and say- I have a friend in the US who wants to own these shares, can you convert my shares into ADRs so that he can purchase them off in OTC market?

Chandra: The scheme that came out last in December does seem to permit it. However, as we will sort of realize through this discussion, there is still a lot of operationalisation that is required to be undertaken in respect of this scheme including with respect to who can deposit shares into the depository facility and how exactly this process is going to work.

Doshi: There is a Reserve Bank of India (RBI) Foreign Exchange Management Act (FEMA) notification that was out in January. Some lawyers tell me there are hoping for some guidelines from SEBI though I am not sure what those guidelines are supposed to do. Others tell me that they expect NSDL will do headroom monitoring and will get to the issue of how these ADRs count towards foreign investment in just a bit. So what are we waiting for in terms of any further regulations, rules or guidelines from any of the Indian regulators to be able to opertaionalise this?

Chandra: To start of, SEBI does not get involved with ADRs and GDRs. These are foreign securities- so to the extent that they remain unconverted into Indian equity shares, SEBI has traditionally never got involved and I do not expect them to get involved. The only place where SEBI comes in to the scene is when or rather how these underlying shares in respect of these ADRs count towards public shareholding for Indian listed companies. Otherwise the primary regulator for ADRs and GDRs has been the Ministry of Finance (MOF) and the RBI. It will be those regulators who will need to put out the sort of clarifications that are required to operationlise this scheme as they have under the erstwhile 1993 scheme as well.

Menaka: Let's try and understand how many more clarifications we need. One clarification I have run into consistently through the course of this week is the question regarding how these ADRs will be counted towards foreign investment limits. Will they be counted as foreign direct investment (FDI) which is typically how ADRs are counted or will they be counted as foreign portfolio investor (FPI) and that will also then impact what constitutes public float for the minimum public shareholding guidelines of 25 percent? Any clarity on this or are you hoping that the Ministry will clarify?

Chandra: That is one of the primary areas that require clarity. To deal with the point that you made on public shareholding, the 2014 scheme prescribes that as long as the ADRs pass on the voting rights on the underlying shares to the ADR holders and are listed on an international exchange then the shares underlying those ADRs should constitute part of the public float of Indian companies. However, the securities contracts regulation rules which deal with this whole issue, still say that shares underlying ADRs and GDRs are required to be excluded. So as it stands right now, there is little bit of inconsistency between the two. I think it is a matte of time before the Securities Contracts Regulation Rules (SCRR) is amended to take into account the provisions of the scheme because that clearly seems to be the intention.

UNSPONSORED ADRs

Depository Receipts Scheme, 2014Underlying shares shall form part of public shareholding

SCRR, 1957‘Public shareholding’ excludes shares which are held by custodian against depository receipts

Menaka: What about how this will be counted towards foreign investment?

Chandra: Under the 1993 scheme, there was an express provision that said that shares underlying ADRs and GDRs will be counted as foreign direct investment and that was the position that was taken and there was no doubt about this. However, under the new scheme there is an ambiguity that has been introduced by the provisions of one particular clause where the clause seems to suggest that the shares underlying ADRs should be counted as FDI. However, the explanation to that clause seems to imply that it would be part of the FPI shareholding. So that is one area that needs to be clarified very quickly. The RBI did put out a circular few weeks back but unfortunately this is an area that they have not touched.

UNSPONSORED ADRs1993 Scheme: ADRs = FDI

2014 Scheme: ADRs = FDI- But Explanation Note suggests ADRs = FPI

Menaka: There is one more issue which has to do with the fact that 2014 depository receipts (DR) scheme says, voting rights will have to be granted to DR holders in the case of such non sponsored depositor receipts. Do you see that posing a problem?

Chandra: I do not see that as being an issue. The way I understand it is any event as far as ADRs are concerned, voting rights are typically passed on to the DR holders under the terms of deposit of payment. It's only with GDR that voting rights are not passed on typically to the holders. The voting rights on those is exercised by the depository in accordance with the instructions of the Board of the issuer company which is the way it's been happening typically till now.

TYPES OF ADRs

Level 1: Non-capital raising

Sponsored: Company is party to Deposit Agreement Company can control terms of ADR program

Unsponsored: Established by foreign Depository Bank Without participation or consent of company/issuer

Gupta: I think it's a welcome development that the scheme requires voting rights for the shareholders, for the ADR holders. Many times in unsponsored programmes you will find that the ADR holders are not given any voting rights. We spoke about the differences between sponsored and unsponsored but one of the key differences in a sponsored one is that it batches those voting rights or requires the depository to do that. So by requiring in a statute, the government has made it clear that they want full protection for the Indian shareholders and the ADR holders.

The second observation I would make is that there is some confusion about issuers calling me and saying, F6 is effective, how can we find our whether what is trading in the ADR and we have just talked about that it is still not operational. So there is a difference. F6 can go effective which is just a form that's filed with the SEC by the depository but that doesn't mean that the depositories are taking any orders for deposits of shares and issuing ADRs. All that is still suspended until all these clarification that we just talked about come into place.

Doshi: What do you fink and if you can list for me sort of concerns that companies have and whether they should be aware of any drawbacks, any new compliance requirements or even legal liabilities even though they are not participating in this process of unsponsored ADRs nor do they have to consent to this process of unsponsored ADRs?

Gupta: I have had many calls with CFOs after F6 were filed and the top most questions I get is - how did someone at a depository file an unsponsored ADR program on my shares without my participation, my consent and even my knowledge. Many clients I call did not even know that they had ADR program filed on their shares. Firstly, the question that I get asked is- does it expose us to SEC reporting obligations? Have I now become an SEC reporting issuer? Answer is no. There is a lot of concern around that among the Indian issuers. The exemption under which this is been filed under the SEC rules allows the issuer to continue with its ongoing reporting obligations that they are doing in India without complying with any additional obligations under the SEC rules. So you do not have to comply with the SEC financials, reporting obligations, disclosure obligations, corporate governance obligations. You can continue with your business as usual and whatever you are doing in India, you can continue with that and you would be okay under the unsponsored ADR program or even a sponsored level 1 in the ADR program.

TYPES OF ADRs- Level 1: Non-capital raising- Unsponsored: Established by foreign Depository Bank Without participation or consent of company/issuer

UNSPONSORED ADRsNon-US company Must have securities registered with SECOr Be eligible for Rule 12g3-2(b) ExemptionUNSPONSORED ADRs- SEC Act: Rule 12g3-2(b) Exemption- 2008 amendment made exemption automatic- If shares listed on exchange in home market - Disclosure documents in English and publically available

Second question you just mentioned is the legal liabilities- again a very top question in the minds of these CFOs and general counsels who have called me. Let us look at what is the benefit or what is the impact of an unsponsored ADR program, what does it do? The primary impact it does is it increases your US investor base; now why is that? Today the investors coming into India have to come through the FII route, the FPI route or even P-notes but all of them have very stringent compliance norms and many of these investors either do not want to comply or not able to comply. There are also investors who want US dollar denominated securities. They want their dividends paid in US dollars. Many of these investors have just one global account in the US. They do not want to go in the local jurisdiction into Moscow, in Shanghai and in Mumbai and comply with the local requirements and so what they want is a security that is traded in their currency and in the home market. So, this unsponsored ADR program or a sponsored level 1 ADR program opens up that market for these investors.

What does it do though? That means I have now a bigger investor base in the US. One could argue that potentially you have more numbers of plaintiffs as we know the US market. However, note that many of these companies have already US investors, many of these companies offered when they did IPO or offerings to qualified institutional buyer (QIBs) in the US. They are already subject to anti-fraud provisions of the federal securities laws. What does that require- there cannot be any material misstatement or omission in your public disclosure which companies have to do in anyway under the Indian law. So long as you are ensuring that, there isn’t a very material increase in the legal liability.

Doshi: One of the drawbacks that you pointed out to me was that because of the expansion in the investor base in the US, companies in a sense loose control over that investor base. Can you elaborate a little bit on that and why you seem to think it is a big negative?

Gupta: That is really the crux of this discussion - when a company calls me and says what do I do? The answer is the best approach is to go to a sponsored level 1 ADR. I will tell you why. The disadvantage of this unsponsored ADR program is you have increased the investor base but what is the visibility with those investors? Zero. The company has no contact with those investors. They are all being handled by the depository. The depositary has a complete discretion on what fees they charge with these investors. So when you convert your shares into ADRs or cancel the ADRs into shares there is a certain fees that is charged by the depository.

The depository can unilaterally set that fee and not have any input from the issuer. The ratio of these shares to ADRs can again be fixed unilaterally by the depository. The shareholder information, the communication that you are making with your shareholders - for example a significant corporate action- you want the shareholders to get that communication and vote on these shares. Depository has no obligations to pass on that information or communication to the shares which are underlying these ADRs under an unsponsored ADR program.

Thirdly one of the biggest advantages and you have seen that in India and some of the clients is there are multiple unsponsored ADR programs that can be filed by multiple depositories. Now you can only imagine the kind of confusion that it can create because one depository could have 3 shares to an ADR ratio, another one will have 4 shares to an ADR ratio, the fees can be very different, the policy they are following vis-a-vis the ADR holders can be very different. So it can cause a lot of confusion. What is the solution? The best solution is to go for a sponsored level 1 ADR program. You can very easily convert an unsponsored level 1 ADR program into a sponsored level 1 ADR program.

What are the benefits? All the disadvantages I just outlined get addressed by a sponsored program. There are also no additional corporate governance requirements. You can comply with this obligation by complying with your already ongoing Indian reporting obligations with no additional SEC obligations. Lastly, but very importantly, with almost no additional cost. The depositary will actually bear most of the cost of setting up a sponsored level 1 ADR program and there is a very minimal either upfront or ongoing cost for the issuers.

Doshi: It does seem a little unfair that if a company does not want to have to do an ADR or does not desire to do one, simply the existence of one or multiple unsponsored ADRs, compels the company to convert into a sponsored ADR and go through all of these things that you have mentioned. There are advantages of a widened investor base but you also got to negotiate with that one depository or the several depositaries- if there are multiples unsponsored ADRs. You have got to negotiate with them to get them to sort of close down those unsponsored ADRs. So it just seems like a lot of pain that a company has to go through for no reason?

Gupta: The benefits can be pretty big. The fact that an unsponsored ADR program has been filed on the company, you can take it has an opportunity and say okay - why don’t I use this opportunity to increase my investor base and also provide these investors with the kind of protection that I would want to provide to all my shareholders. On the point about multiple ADR programs being terminated, it is simple - you appoint one depository and that depository will than go and talk to the other depositories and most of these depositories will be willing to terminate their programs and roll them into the primary sponsored level 1 ADR program.

Doshi: In a conversation with me you also brought up the issue of potentially higher risks of hostile takeovers?

Chandra: It ties into what I was saying in terms of the opaqueness around unsponsored programs because what we have been hearing is that people are a little bit apprehensive about the fact that anybody could go in and buy shares of their companies and deposit it into a unsponsored ADR facility and then the company basically has no visibility over who is acquiring the shares. They do not know who the shareholder is, they do not know who is behind that shareholder and there is no visibility. The only way to get around that is, as Rajiv was saying, put a sponsored program in place because that at least gives you the visibility.

Doshi: Do you think this is a good development for India, Indian issuers and in some sense even the Indian capital markets- the kind of investors that Indian issuers attract- because there is some fear here amongst market participants that this leads to the exporting of Indian capital markets?

Gupta: It is a fantastic development according to me. Just taking you back in history a little bit - back in 2008 - when the SEC rules got amended in the US that facilitated the setting up of these unsponsored ADR programs. Just to give you a sample- more than 1000 of these unsponsored ADR programs were set up globally on the companies. Of course India was not one of them because Indian regulations did not allow that and in many of these we helped many of these companies to turn them into sponsored level 1 ADR program.

So you can see this is not just an Indian phenomenon; it is a globally accepted phenomenon where people see the benefits of setting up an unsponsored program and then turning them into a sponsored level 1 ADR program. In terms of exporting - if the liquidity in the market is increasing, any investor in the US wanting to buy ADRs will have to instruct its broker to buy shares in Mumbai, then it is really an increase in the liquidity and the trading. So I do not see that necessarily as exporting; you are increasing your investor base which can only be a good result from any company’s liquidity perspective.

Chandra: It is a good development; it will offer Indian companies a chance to increase visibility to attract a wider investor base. Over all it is a good development - of course there are still sort of kinks that have sort to be ironed out.